Deleveraging, short sale constraints and market crash

Abstract: In this paper, we develop a theory of market crashes resulting from a deleveraging shock. We consider two representative investors in a market holding different opinions about the public available information. The deleveraging shock forces the high confidence investors to liquidate their risky assets to pay back their margin loans. When short sales are constrained, the deleveraging shock creates a liquidity vacuum in which no trades can occur between the two representative investors until the price drop to a threshold below which low confidence investors take over the reduced demands. There are two roles short sellers could play to stabilize the market. First, short sellers provide extra supply in a bullish market so that the price of the asset is settled lower than otherwise. Second, short sellers catch the falling price earlier in the deleveraging process if they are previously allowed to hold a larger short position. We apply our model to explain the recent deleveraging crisis of the Chinese market with great success.